Mises Wire

The "Lucas Critique" Is Misesian at its Core

Robert E. Lucas Jr. won the Nobel Memorial Prize in Economic Sciences in 1995 for one of the most celebrated contributions in modern macroeconomics: the Lucas Critique. His article on econometric policy evaluation, originally published in 1976, according to many leading economists sparked a genuine methodological revolution in macroeconomic analysis.1 He emphasized that the underlying coefficients of traditional econometric models are not constant. Hence, these models were inadequate for counterfactual policy evaluation. In other words, these models were inadequate for scientific predictions of the effects of political interventions into the economy, and thus incapable of prognostic comparison of alternative political interventions.

The Limits of Macroeconomics

The traditional Keynesian and Monetarist models of the 1960s and 70s could not scientifically predict whether, for example, an expansion of the money supply would really lead to lower unemployment rates — not to mention the extent of the effect. The problem is that correlations between macroeconomic aggregates like price inflation and unemployment are constantly changing. When a certain correlation has been observed for the past, one cannot simply assume that this correlation will hold for the future, especially when policymakers try to exploit the correlation. The political environment has an impact on human action and can itself lead to changes in the observable correlations between economic variables.

In order to solve the problem of counterfactual policy evaluation according to Lucas one would have to identify “structural equations” whose coefficients remain constant over time. Only when the coefficients are constant, can econometric methods of estimation and testing be applied adequately. It has been argued that the microfoundation of macroeconomic models established as a result of the Lucas Critique has accomplished exactly this. The so-called dynamic stochastic general equilibrium (DSGE) models postulate representative households and firms, whose behavior is derived mathematically in consideration of the political environment. The behavior of the household is a constraint on the profit maximization problem of the firm and the firm’s decisions are constraints on the utility maximization problem of the household. The authors of these models claim that all relevant feedback effects are incorporated. DSGE models thus form a closed system in which the effects of any political intervention, such as a cut in interest rates, can be estimated sufficiently well. It is claimed that the new models have overcome the Lucas Critique.2 But is this claim justified?

In a recent publication I argue that it is not.3 The fundamental problem indicated by the Lucas Critique has not been solved by modern modeling methods. The problem of inconstancy of observable relationships between economic variables, that is variables that are the outcome of human action, cannot be solved. As long as modern macroeconomics follows a positivistic-econometric approach it will be exposed to it. It is so fundamental and pervasive that it cannot be avoided. Hence, it is of utmost importance to openly admit that the problem exists, instead of sweeping it under the rug, and in fact to question and challenge the common methods of modern macroeconomics thoroughly.

Economics Is Not Like the Physical Sciences

A more detailed analysis of the problem can be found in the epistemological and methodological writings of Ludwig von Mises and Hans-Hermann Hoppe.4 According to Mises, a proponent of methodological dualism, there are no constants in human action that would justify a natural scientific approach to economics. The search for “structural equations” must thus be seen as a futile endeavor.

For example, in order to falsify a hypothesis on the basis of empirical data, we must assume the constancy principle to hold. It implies the following principles of causal empirical research: “equal cause, equal effect” and “unequal effect, unequal cause,” and it categorically excludes the possibility of contingencies in the way causes exert their effects.5 When we observe the same characteristics for the explanatory variables A, B and C for two different data samples, but different characteristics for the explained variable Y, then we could only conclude that there must have been at least another explanatory variable D that can account for the difference if the constancy principle is actually satisfied. The hypothesis can then be adapted and tested against another data sample. Hence, the constancy principle, if satisfied, allows a gradual convergence towards the truth. When it comes to natural sciences the assumption of the constancy principle is rather unproblematic. However, is it also reasonable to assume constancy for social phenomena?

The crucial questions are the following: Can we reasonably assume that human action follows the constancy principle, i.e., does a certain configuration of causal factors always exert the same effect on human action? Or can human action be different given the same configuration of observable causes?

No and yes, respectively. The constancy principle cannot be justified for social scientific phenomena, and humans can act differently under apparently identical conditions. Hoppe has given this intuitive insight a rigorous foundation. Ironically his argument builds on Karl Popper’s critique of historicism.6

Popper argued that we cannot scientifically predict the future state of our knowledge, precisely because humans are capable of learning. Yet our knowledge shapes the course of history. Hence, there can be no scientific theory of the course of history and no scientific predictions of the future course of history. In particular, Popper opposed the views of Marx and Spengler.

The capability of learning, however, also implies that human action in general cannot be predicted scientifically as knowledge influences action. “Structural changes” that completely mislead a hitherto well-functioning econometric model are always possible.

The traditional Keynesian and Monetarist models had not predicted the structural change of stagflation in the 1970s and 80s. But also the modern DSGE models did not predict the Great Recession of 2008. There are studies showing that the modern models would not have made any better predictions, had they been used instead back in the 1970s.7 In light of this result the actual advances in macroeconomic modeling do not seem to be as big as its most outspoken proponents would have us believe. In particular, the Lucas Critique has not been overcome. Of course, Lucas was by no means a Misesian. Yet, rightly understood, we can find a Misesian core in his celebrated contribution: “There are no constants in human action.” The constancy principle is not satisfied when it comes to social scientific phenomena, which are the result of human action. This claim is valid from the point of view of learning human beings. Since presumably we all belong to that category it carries some weight.

But Mises also writes:

Mortal man does not know how the universe and all that it contains may appear to a superhuman intelligence. Perhaps such an exalted mind is in a position to elaborate a coherent and comprehensive monistic interpretation of all phenomena.8

Hence, the dualism between natural and social sciences that Mises advocates must not be understood as a claim to absolute truth, but as a methodological necessity.

Karl-Friedrich Israel is a lecturer at the University of Angers; a PhD candidate studying with Jörg Guido Hülsmann at the University of Angers; and a 2016 Mises Institute Fellow. Contact: email.